Diagnosing Health-Care Stocks

April 11, 2002

This will be a challenging year for pharmaceutical stocks, but other areas in health care merit investor attention. So says Robert Gold, group head for coverage of health-care and consumer staples stocks at Standard & Poor's. In particular, he cites medical devices, hospitals, HMOs, and biotechnology.

S&P now has an avoid rating on Merck and a sell on Eli Lilly, Gold reports. He thinks it will be 2004 before new products significantly add to the revenue stream for such pharma companies. In the meantime, however, Gold and S&P have a strong buy on Johnson & Johnson, partly because of its role in such promising new fields as medicated stents -- which also have potential for Boston Scientific and Guidant. Among companies making medical devices, he names as favorites St. Jude Medical, Stryker, and Steris.

While some people think generic-drug makers look like an investment opportunity, Gold cautions that most have a very narrow window after a patent expires. He points out that S&P now has a sell on Barr Laboratories because the market for generic Prozac has become so competitive.

Gold's comments were made during a chat on Apr. 9 presented by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Edited excerpts follow. A full transcript is available from BW Online on AOL at keyword: BW Talk.

Q: Robert, the market has mostly been drifting lower. What kind of direction does S&P see for the market now?

A: S&P generally expects the market to be stuck in a trading range over the next month or so. S&P recently lowered our yearend target for the S&P 500-stock index to 1,225, which represents a 9% gain over the coming nine months. Although economic conditions bode well for a resumption of growth in the second half of the year, we're concerned about Mideast tensions, rising oil prices, and generally soft corporate earnings in areas such as tech and elsewhere.

Q: How about the stocks your group follows? How have they been doing?

A: Within the health-care sector, we're presently expecting the group to deliver returns in line with the market. Within that area, we are not bullish on pharmaceutical stocks and prefer to invest in other areas such as medical technology, HMOs, hospitals, and biotechnology.

Historically, the health-care sector performs well when market uncertainties drive investors into relatively safe havens. However, the problems evident in the pharma group have removed some of that defensive characteristic, and the group's performance has suffered as a result. Having said that, there are areas that clearly play into the demographic trends evident both in the U.S. and abroad. These include medical devices such as orthopedics and cardiology devices. But it also extends to areas such as hospitals, rehab facilities, and HMOs.

Q: Is Johnson & Johnson (JNJ) too expensive now?

A: J&J is rated a strong buy. It's one of our favorites. On a p-e basis, the stock looks expensive. However, with more than $7 billion in free cash flow generated each year, we think that a better approach is using a discounted cash flow model. Based on our projections over the coming 10 years, which includes a significant amount of incremental growth from their device business, we think the stock is worth upward of $70 a share.

Q: You said biotech was a preferred area. What are some hot small-cap biotechs? Is Medarex (MEDX) or Atherogenics (AGIX) better?

A: We follow only Medarex. And we have that rated a 4-STAR [accumulate, in S&P's Stock Appreciation Ranking System]. Within biotech, the risk-reward profile [for small caps] now is not as favorable as in some of the larger caps. So we're not recommending investors allocate a large chunk of their capital to small-cap biotechs. Our favorites in the group include Amgen (AMGN), Cephalon (CEPH), and Genzyme (GENZ).

Q: Schering-Plough (SGP)?

A: We have Schering-Plough rated a hold. Our concerns are that Schering has a relatively thin research pipeline. And we don't think the new version of Claritin will drive significant new sales and earnings opportunities. Absent a merger, we don't think the stock has any meaningful catalyst on the horizon.

Q: When do you see a turnaround in drug stocks -- for example, Merck (MRK), Lilly (LLY), and GlaxoSmithKline (GSK)?

A: We presently expect all of 2002 will be a very challenging year for the pharma group. In reality, it's not until 2004 when the new products for many of the players start to meaningfully affect revenue growth. We recently turned much more bearish on the drug group and presently recommend investors avoid Merck and sell Eli Lilly.

Q: What do you see ahead for Cardinal Health (CAH)?

A: It's a great company, broadly diversified, with what we believe is an overly rich valuation. Although the drug-distribution area is a compelling long-term play, we prefer other names, including Caremark (CMX) and AmerisourceBergen (ABC).

Q: Your thoughts on Possis Medical (POSS)?

A: Unfortunately, we don't cover POSS. However, we do follow Edwards Lifesciences (EW), which competes in a similar space.... Edwards is presently ranked 3-STARS [hold]. However, the company has several catalysts on the horizon. And it's a stock that carries a valuation well below the group's average. S&P is optimistic about the company's prospects in the heart-valve market, and we believe revenues from their peripheral vascular business add some significant incremental growth for 2002.

Q: Medical devices is one of your special areas, Robert. What are some of your other favorites?

A: Within medical devices, we presently have 5-STAR [buy] opinions on St. Jude Medical (STJ), Stryker (SYK), and Steris (STE). St. Jude is a company that probably offers the most upside at current levels, due to its participation in the rapidly growing implantable defibrillator markets. The company also participates in the cardiac surgery and pacemaker areas. St. Jude is poised for 2002 revenue growth upward of 16%, which is far superior to its peer group. And yet it trades at a reasonable four times sales, which is in line with its peers.

One of our other favorite areas is orthopedics, and our top name there is Stryker. The company is a dominant player in joint replacement, where it sells products including knee, hip, shoulder, and spinal implants. But it also has exposure to surgical instruments and other hospital equipment. Stryker has a long history of 20% operating earnings growth, and we think that trend will continue in both 2002 and 2003. We expect Stryker to generate 2002 free cash flow of $350 million, and our target price based on that assumption is $70 a share.

Q: You also mentioned Steris as a buy. Tell us a bit about it.

A: Steris primarily makes sterilization systems for health-care facilities. But its technology also has been used in the sterilization of food products and has an interesting opportunity to be used to sterilize U.S. mail. The company has been discussing ways to leverage this technology with the U.S. government, and although our buy rating isn't based on that application, it would be a significant positive event.

Steris should generate free cash flow in fiscal '02 [ending in March] of $55 million, and we have a 12-month price target of $25 a share. It's now trading around $21.

Q: Do you think Abbott Labs (ABT) is back on track for steady earnings growth?

A: We like Abbott Labs -- it's now rated accumulate. Sales to hospitals were very strong in the first quarter. And the Knoll acquisition has performed very well. This morning, ABT lowered its second-quarter earnings guidance but confirmed the full-year expectation. That expectation was between $2.24 and $2.26 [per share]. The stock is priced in line with the drug group but at a 20% discount to its fair value, based on our discounted cash flow model.

Q: How about Apria Health Group (AHG)?

A: We have hold opinions on both Apria and Lincare (LNCR) [in home health-care services]. We are concerned about the prospect for Medicare rate reductions. It's not an area we're presently emphasizing.

Q: What do you like among hospitals and HMOs?

A: One of our longtime favorites has been Tenet Healthcare (THC). We began recommending the stock in May, 2000, at $26 a share. THC this afternoon reached a record high of $70. Despite that surge, THC remains priced generally in line with its hospital peer group, which reflects a steady flow of upward guidance to both revenues and earnings. Tenet should generate nearly $2 billion of free cash flow this year and earnings growth of about 40%.

Recently priced at 18 times our fiscal '03 EPS estimate, THC remains underpriced. We have a price target in the high 70s.

Q: Are there any stocks you like that own or manage nursing homes? Or does your Medicare worry apply here?

A: Our coverage currently extends to only one company, Manor Care (HCR). Although we have the stock rated accumulate, the pressures on Medicare to lower reimbursements to nursing homes, as well as similar pressures at the state level, are likely to limit the gains in these stocks over the near term. My concern is that our current EPS estimate of $1.36 for 2002 is at risk from these pressures.

Q: Any comments on the generic-drug sector -- and any favorites within the sector?

A: The perception is that the struggles for the branded pharma makers translates into success for the generic makers. In reality, generic makers have a narrow window of opportunity when a drug comes off patent. When that window closes, margins tend to fall sharply, and stocks in the group are extremely volatile on the whole.

We don't have 5-STAR opinions on any generic-drug makers. We do, however, have a sell rating on Barr Laboratories (BRL). That reflects concerns over a dramatic drop in revenues and earnings in fiscal '03 [June], when generic Prozac markets become intensely competitive.

Q: Do you know anything about medicated stents?

A: Medicated stents are a significant new growth opportunity. This holds true for both the device makers, such as Guidant (GDT), Boston Scientific (BSX), and Johnson & Johnson...[and] makers of drugs used to coat the stents. J&J is clearly leading the pack in terms of clinical development, and we expect the company to potentially generate $2 billion in sales by mid-2004.

Guidant is also making nice progress in its clinical trials. That company has adopted a strategy of developing several drugs as coatings, which may allow it to make up a significant amount of time against J&J. We have GDT now ranked accumulate, and J&J is a strong buy.